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Larson on Risk Relievers for Your Stock Portfolio

How Morningstar's Paul Larson uses moat ratings, fair value discounts, opportunistic- and confidence-driven position sizing, and a healthy dose patience to control risk in the StockInvestor portfolios.

Jason Stipp: I'm Jason Stipp for Morningstar, and it's Risk Control Week on Morningstar.com. We're talking about the different types of stock risk that investors have to deal with today and I'm pleased to be joined by Morningstar's Paul Larson. He is Editor of the Morningstar StockInvestor and an equity strategist with us.

Thanks for joining me, Paul.

Paul Larson: Thanks for having me.

Stipp: So the first question for you, there's all sorts of different risks that you can talk about as it pertains to stocks, but I think the primary one, the one that people tend to think about first is operational risk. How risky is this business that you are investing in?

One of the ways that you look at this is the economic moat rating at Morningstar, and we talk about wide-moat stocks having these competitive advantages. What does that mean in terms of risk? Why is a wide-moat stock maybe less risky?

Larson: Well, when a company has competitive advantage that gives it a wide economic moat, that means that it is protected from competitors, and it has some sort of characteristic that is going to allow it to have those positive economic profits, those returns on invested capital that are in excess of its cost of capital.

And I think that having that competitive advantage protects the business, gives it something that it can hang on to, where if it has competitors that don't necessarily have that competitive advantage, don't have an edge, they are much more exposed to the broader economic situation.

Stipp: So I think you think about a company then – it really starts to become apparent in a downturn, for example, when all companies maybe are suffering a little bit, but a wider moat company perhaps could have a pricing power or something where it can maybe maintain those margins in a downtime?

Larson: Exactly. Let's say you're a retailer and you are a company like Wal-Mart and you have a 20% return on invested capital versus your run-of-the-mill retailer that only has a 5% or 6% return, and let's say all returns fall by 5%, well, Wal-Mart is still going to be profitable, still going to be generating economic profits, adding to its intrinsic value, where the regular retailer is going to be at no profit or maybe even slightly in the red.

Stipp: So, it really becomes apparent then in those pinch times.

So I think after that recent downturn that we had, investors are much more risk averse, so they are much more sensitive to risk. When you are looking at stocks and when you are thinking about stocks, what do you see as a possible operational risk factor that a lot of investors miss that they are not seeing when they are looking at the numbers?

Larson: Well, one thing to keep in mind is operational leverage--that if a company is going to have a revenue that is down a 5%, then it's typically not going to mean that profits are down 5% because they have fixed costs. And that means that with that operational leverage, the profitability, the profits are going to actually fall more than the revenue, say, with that 5% revenue drop that they are going to drop 10%.

Stipp: So maybe in a good time a company with lot of operational leverage could really shoot up, but in a bad time you really start to see the other side of that sword there?

Larson: Absolutely.

Stipp: So moving on to price risk, which is, I think, also a risk that investors sometimes don't think about, they find a great business and they're like, "This is perfect, I like how the operations are, I'm going to buy it," and they don't think about how much they are paying.

How do you think about pricing when you are buying a company, making sure you're not overbuying or taking on too much price risk?

Larson: Well, I think that focusing on the fair value estimate and making sure to buy at a significant discount to that fair value estimate in order to give one a margin of safety, that's how I personally try to avoid that price risk. If something is worth $75, not paying only $70, but looking to really buy at a significant margin of safety, call it below $50.

Stipp: So, really no matter how great the business, you don't want to pay too much for it, even if it's got a really good underlying fundamental there.

But on that same point, is there a time when a company that maybe doesn't have great operations, that hasn't been run well in the past becomes so cheap that it actually seems like it could be a good investment because you have what looks like a big margin of safety?

Larson: Well, I would say this is not the strategy that we advocate in StockInvestor, but it is a strategy that some have pursued. But it's one that you have to pursue with great care because when you buy a no-moat stock that is incredibly cheap, some call these the cigar butts, then all you are hanging your hat on is the price.

And if you are wrong in your assessment of the price, you really don't have anything else to go on, where if you focus on buying wide-moat businesses, if you are wrong in your price, okay, well, maybe you burn through your margin of safety, but at the end of the day, you are still going to own a company that has competitive advantages, that is going to be generating economic profits and increasing in intrinsic value at above average rates over time.

Stipp: I think another point with those no-moat companies, those cigar butts, you also sort of have to know when to sell. These aren't companies that you probably would want to hold for a long time. And so, it's really having to make the buy and the sell decision, where a wide-moat company probably you could hold indefinitely or for a while anyway because of those strengths that it has in the business.

Larson: Yeah. I think a good way of summing it up is when you buy no-moat stocks, time is not on your side; when you buy wide-moat stocks, time is on your side.

Stipp: Paul, moving on to your portfolio and thinking about risk at the portfolio level and your position sizes, how do you mitigate maybe having a lot of concentration in the portfolio or a lot of your portfolio funds in one or two names versus the other funds that might have less?

Larson: Well, I think that concentrated positions are okay, but those should be reserved for the stocks that one has the most confidence in, both the underlying business as well as one's projections. And I think you can say that we advocate keeping eggs in slightly fewer baskets and watching those baskets very, very closely.

Stipp: So would you say if you had a company that really was performing quite well, but maybe relative to other positions in the portfolio, there was more uncertainty that it reaches a point where you might just trim that because the position size just doesn't match your confidence level?

Larson: Yes. I do a lot of trades where I am trimming or so-called doubling down on positions and altering the position sizes, and I think that that's a smart strategy.

Stipp: And also, if you see a lot of opportunity elsewhere that could be maybe even better than some of the positions that you have now, could be another time to maybe trim those lower confidence ones and buy something that – higher confidence and maybe even a better price?

Larson: And also the price too. I always like to say that it's okay to sell the dollar bill trading at $0.80 if you can turn around and reinvest that capital buying another dollar bill that's trading at $0.50.

Stipp: Good point. Last question for you, and I think we really saw this in the recent downturn in 2008, everything looked like it was going down at once, and at that point any kind of diversification that you've been doing, any kind of confidence position-sizing you've been doing seems to not matter at all. It seems like everything is correlated and in a bad way.

How do you think about managing a portfolio when there is potentially these larger macro or systemic risks going on out there that could just sort of wipe everyone out for a while?

Larson: Well, I think in times like that patience is really an order. And it's worth noting that, when everything goes down, very rarely does everything deserve to go down. So that means that there are going to be opportunities at those times in the market.